The Canadian fixed income investment universe if fairly limited. Corporate issues tend to be dominated by a few sectors, and only the larger provinces have enough outstanding debt to make an impact on the Canadian investment-grade benchmark: the FTSE TMX Canada Universe. To broaden their exposure, investors can look outside our borders.
The most obvious reason to invest globally has to do with diversification. We've heard it a million times: don't put all your eggs in one basket. Investing only in Canada exposes investors to the actions of a single government or central bank. Investing globally can help lessen this risk by exposing investors to economies that tend not to move in lockstep.
But investing abroad also exposes investors to currency movements -- something they don't have to worry about when investing domestically. The return of a foreign investment is the combination of the return of the asset in foreign currency terms and the return of the foreign currency. In a simple example let's assume we buy a UK government bond (also called a Gilt) at par value for £1,000. A year later it has gained 10% and is selling for £1,100. But that's not necessarily our return. We'd have to combine the return with the return of the British pound. If the pound gained 10% over the year, we would have made approximately 20% in total (10% from the bond and 10% from the currency appreciation), and be even if the Pound lost 10%.
Uncertainty or less uncertainty?
Currency movements are often dictated by government policies on interest rates and inflation, which can be hard to predict. That's why many portfolio managers will hedge away the currency exposure. But hedging global bonds can be a little more complicated than hedging global stocks, as many bonds distribute income monthly. This means a portfolio manager would need to set up a series of hedges, which adds to the costs of running the portfolio.
So the obvious question is: is it worth it? The answer can differ from one investor to the next. For some investors, the currency uncertainty may be too much to handle. For those investors, there are funds like RBC Global Bond 
which is rated Bronze by Morningstar analysts and hedges at least 85% of its currency exposure. The fund also tries to add value through currencies by actively taking small positions in the remaining 15%.
There are also global bond exchange-traded-funds that hedge away currency exposure. BlackRock offers four currency-hedged foreign bond ETFs in its iShares family – including two U.S. high-yield bond funds. A word of caution here: some these ETFs don't always track their benchmarks perfectly and can trade at a bigger premium or discount compared to broad ETFs tracking core benchmarks.
Though it can lower uncertainty, hedging global currencies can also limit a fund's diversification potential because it tends to increase its correlation with local bonds. For example, the unhedged version of the Citi World Government Bond Index has a correlation of 0.5 with the FTSE TMX, while the hedged version has a much higher correlation of 0.8.
There are fund managers who actively manage their currency, making decisions on the currency exposure primarily to add value, either through protecting the fund or adding returns. Michael Hasenstab, manager of the Bronze-rated Templeton Global Bond , has maintained no exposure to the Japanese yen with the view that the currency was going to depreciate. The move has worked well for investors in the fund. Hasenstab has also been short-selling the euro, another move that has benefited investors.
But that doesn't mean that a fund that claims to add value through currency management necessarily does so. In the case of Templeton Global Bond, the fund has one of the largest teams in the world backing it. This team hits the pavement when conducting its country research, meeting with local policymakers, business leaders, journalists and others. Few other funds can boast such resources. So when picking a fund that makes calls on currencies, find out what this fund does differently that allows it to predict currency moves better that the plethora of economists and "experts" trying to do the same.
Your portfolio
Investing in any fund depends on an investor's risk tolerance level, and investors should always account for how a fund will interact with their overall portfolio. When choosing between hedged and unhedged global bond funds, investors need to remember the trade-offs.
Hedged strategies will have a lower level of uncertainty because you're getting rid of one of its drivers -- currency return. However, they can also have higher correlations to domestic bonds than unhedged strategies. This limits the diversification potential and may make hedged strategies less attractive when building an overall portfolio.
On the other hand, unhedged global bond funds carry higher uncertainty, but their lower correlation with other asset classes can help build more diversified portfolios and may even lower the volatility of an overall portfolio. Between these two, hedging simply gives investors the option to choose what risk they want to take on.
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